Tuesday, February 5, 2008

What Goes Up…

Despite the increases in interest rates over the last five years, housing continues to spiral upwards in price. Inflation too has been increasing over the past two years and is now around 4%. For whatever reason, the conventional wisdom is that inflation must be cut off by increasing interest rates. Put simply, the increase in interest rates reduces the consumer’s spending power, thus reducing the upward pressure on prices and slowing inflation. Neat isn’t it.

It’s also wrong. The greatest price increases contributing to the growth in the consumer price index are the cost of housing and the cost of financial services. Both of these are themselves sensitive to interest rates so pushing up rates only makes the problem worse. Not only that, but if inflation is considered to be driven by consumer spending, then the increase in interest rates will unfortunately hurt most those who are least responsible for the problem. It’s not the battlers and the pensioners who are spending up big, but they are the ones who will feel the crunch most.

The real problem confronting us remains the staggering gap between house prices and everything else. At around eight times average income, average house prices are well beyond the reach of average people, and it’s only getting worse with price growth in double figures in many parts of Australia. If increasing interest rates was going to have an impact we would have seen the signs of it by now. Instead, interest rates and prices are both going up.

These circumstances are increasingly taking on the characteristics of a bubble, and unless steps are taken to deflate it gently, that bubble will ultimately burst. Interest rates and inflation are not the main issue here. It’s the inflated capital value of real estate that is the real problem.